Like others, we're watching the trumpeted "Blue Ribbon Panel" on accounting standards for private companies. Unlike others, our expectations are very low because we aren't confident this group understands what reforms are needed.

Certainly, one can and should throw stones at much of GAAP, whether the focus is on public or private companies. Unfortunately, it's clear that the panel members aren't addressing fundamental flaws that affect statement content. Instead, their goal is to simplify the reporting process so they can reduce out-of-pocket costs, even though that would mean less informative reports.

For example, we expect them to cling to traditional duh-preciation and off-balance-sheet financing. They surely want to roll back disclosures about instruments and derivatives and eliminate mark-to-market practices. Could it be they want private company statements to look like simplistic accounting textbook examples?

We're pessimistic because the 18-member panel predictably includes eight preparers and four public accountants. The other third consists of two regulators, a lobbyist, an academic, and two venture capitalists as token statement users. History shows that this domination by statement preparers and auditors will produce recommendations that are all about making private company financial statements easy to prepare and audit, with only lip service to providing users with information they need.

Bruce Pounder, writing for CFO.com, unveiled a telling manifestation of user neglect when he wrote, "[I]n response to the panel's solicitation of written input from interested parties, only four responses came from lenders and owners, and none came from sureties. In contrast, 103 responses came from CPA firms and state CPA societies."

Our explanation is that CPAs with practices focused on small private companies want relief from learning and explaining new GAAP. On the other hand, users opted out because they don't see any point in participating in a process that's totally stacked against them. In any case, this domination is a sure recipe for the worst kind of tunnel vision.

 

TWO MISTAKES AND TWO GOALS

We predict the panel is obsessed with two clearly wrong points while missing two clearly important goals, just like other past anointed groups with imbalanced memberships.

The first mistake is the premise that private companies need less complex statements. To the contrary, a private company is not necessarily less complex; rather, its business model determines whether its statements should be simple or complicated. If management elects to, say, establish defined-benefit pension plans, seek off-balance-sheet financing, or engage in derivatives transactions, they have created demand for complex financial statements and, in turn, complex standards to help those statements faithfully represent the company's true state.

The second and equally important mistake is failing to understand what private company financial statements could be used for in order to be worth preparing. We're convinced that private company statements must support two primary goals: (1) assessing creditworthiness and (2) assisting owners and prospective buyers in acquisitions. Simply put, they must provide information that is useful to existing and potential creditors and owners.

Because the panel's members have not demonstrated that they comprehend these user-oriented goals, we predict that their tunnel vision will focus on producing dumbed-down financial statements.

In contrast, they should put users' needs first and aim to produce statements on steroids! What would these beefed-up statements describe? It's all about cash flows and cash-flow potential.

 

CASH FLOWS AND CASH-FLOW POTENTIAL

To serve existing and potential creditors, statements must usefully describe actual cash flows so they can be compared to existing and potential debt service requirements; the cash-inflow potential of all assets that could provide collateral or cash for repayment; and the cash-outflow potential of all liabilities and their impact on future payments.

To serve existing owners, financial statements must usefully describe actual operating and other cash flows to inform judgments about their sufficiency for supporting survival, growth and dividends; value residing in all assets to gauge whether the return justifies maintaining the current operating strategy or encourages selling out; and potential value drains associated with investing and financing transactions.

Because a private company lacks a consensus market stock price, potential buyers (and sellers) don't have a ready-made external starting point for estimating an enterprise's worth. Instead, they start with blank slates and build their own estimates using financial statements and other data sources. Their needs are best met by reports that usefully describe the market values of all assets and liabilities, including those conventionally left off the balance sheet under GAAP, and actual cash flows. Further, because volatility reveals risk, they certainly need income measures that are not smoothed.

 

WHERE IS THIS HEADED?

Dumbed down financial statements would not serve any of those purposes. Regular GAAP balance sheets already underserve users' needs by attaching allocated book values to assets and liabilities, and failing to recognize other very significant ones, such as those associated with leases and research and development. Obviously, appreciated real property is almost always grossly undervalued at historical cost, such that owners who provide GAAP balance sheets to their creditors or potential buyers should not want them to believe what they read! Dumbing them down won't help at all.

Here's how our steroid-enhanced private company statements would be different.

For starters, the cash-flow statement would use the direct method, instead of the impenetrable indirect format. What good does it do to confuse people who could lend you money or buy your company? Do you really think it will get you the best results? We're convinced that not giving them useful information either sends them down the road to look for better opportunities or compels them to offer tougher credit terms or a lower purchase price for the company.

Next, all assets and liabilities would be presented on balance sheets at their market values, not historical book values or one-sided impaired values. Anything other than market value falls well short of serving users' needs and makes it less likely that owners can borrow at fair rates or get full value from selling their companies.

Third, net income would not be smoothed with artificial deferrals or by relegating unwanted income to other comprehensive income on the balance sheet. This would mean, for example, no systematic duh-preciation, no predetermined allocated interest costs, no LIFO inventory measures, no deferred income taxes, and no hidden unrealized gains and losses.

Fourth, information would be totally accessible because disclosures would ensure that users know the truth, the whole truth, and nothing but. The footnotes would fully explain valuations and margins for error; after all, if management doesn't willingly provide this information, users defensively assume that the measures are unreliable and build cushions in their favor. In other words, owners can be hurt by what creditors and buyers don't know. Ironically, we suspect that this panel contemplates fewer disclosures, as if a secret silence would encourage users to grant favorable loans or offer higher purchase prices.

Fifth, audit opinions would affirm that management's representations are true, not just repeat a rote declaration that they complied with arcane, politically compromised accounting rules. If auditors don't transform their mission, lack of confidence in the statements will cause potential creditors and buyers to just move on to other opportunities or protect themselves with high interest rates or low-ball offers for the stock. No one, not even auditors or management, should want to create nervous statement users.

Finally, we would increase reporting frequency to further reduce users' uncertainty. However, we expect this panel to advocate reverting to semi-annual or annual reporting to cut preparation costs. Of course, doing so ignores the high costs imposed on users and the devastating effects of their unresolved questions. It also overlooks their freedom to take their money elsewhere.

 

ABOUT THAT NEW BOARD

When we were composing this column in mid-January, the panel had announced that it wants a new board to set private standards. We're sure they expect it to be populated by like-minded preparers and auditors with the same tunnel vision.

We like the idea of a new board, too, but not if it is set up to get mired in the same political swamps that the Financial Accounting Standards Board has to slog through every time it wants to reform GAAP.

We believe a board composed of honest-to-goodness financial statement users will best serve the important objectives. They would be bank loan officers, not chief executive officers or chief financial officers. They would also be entrepreneurs who have bought and sold numerous businesses and know what information is really useful. And they would be financial analysts who understand the negative impacts of incomplete or otherwise manipulated information. Finally, we see no need for auditors on this board, at least any who have a mindset that, when push comes to shove, elevates their own safety above helping their clients and the capital markets.

 

WILL IT HAPPEN?

We think our reforms really ought to happen because the economy would be boosted by increased efficiency in this critical sector's capital markets.

Realistically, we fear that this panel, like others who went before, will do nothing but conjure pseudo-reforms that merely re-arrange the deck chairs on the Queen Mary. That ship, of course, is permanently moored at a pier in the Port of Long Beach in California, and will never again sail in a real ocean. Oh, sure, she'll never sink, but she can't take anyone where they want or need to go.

Bottom line, this panel's tunnel vision will produce nothing but wasted energy, time and money, all while losing an opportunity to accomplish something really useful, like financial statements that managers would actually want users to believe and, dare we say it, use to make better decisions.

 

Paul B. W. Miller is a professor at the University of Colorado at Colorado Springs and Paul R. Bahnson is a professor at Boise State University. The authors’ views are not necessarily those of their institutions. Reach them at paulandpaul@qfr.biz.

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